Valuation of Bankrupt Firms

Abstract

This study compares the market value of firms that reorganize in bankruptcy with estimates of value based on management's published cash flow projections. We estimate firm values using models that have been shown in other contexts to generate relatively precise estimates of value. We find that these methods generally yield unbiased estimates of value, but the dispersion of valuation errors is very wide—the sample ratio of estimated value to market value varies from less than 20% to greater than 250%. Cross-sectional analysis indicates that the variation in these errors is related to empirical proxies for claimholders' incentives to overstate or understate the firm's value.

More from these Authors

Gemini Investors was a private equity firm focused on small and lower middle market businesses. Gemini's target investment size was between $4 million and $6 million and a typical portfolio company had revenue of between $8 million and $30 million. In early 2015, Gemini was completing the investment of Gemini's Fund V and it was deciding whether it should raise a fund sized similarly to their prior funds, or alternatively, raising a significantly larger fund.

Harriett Green, the newly appointed CEO of Thomas Cook Group, faces a daunting set of business and financial challenges at the 171-year old UK travel services company. The company has lost almost £600 million in the last three quarters; has seen its stock price fall from 230 pence to a low of 8.8 pence in the past two years; and had seen its bonds trade down to as little as 40% of face value. In just a few weeks the company's license to operate is to be reviewed by the United Kingdom's Civil Aviation Authority, competitors are publicly questioning the company's viability, and seasonal working capital needs are about to peak. With the company's very survival at stake, Green must devise a turnaround plan that will return the company to financial health. Any plan must address the company's high cost structure, raise substantial new capital, fix the balance sheet, create a profitable growth strategy, and build a more effective organization and culture. But achieving all of these objectives within the short time available will be a major challenge.

The June, 2013 bankruptcy of the City of Detroit, Michigan was, at the time, the largest municipal bankruptcy in American history. Detroit had struggled for years with a weakening tax base, high unemployment, a heavy debt load and increasing retiree costs. These financial strains led to cuts in basic public services, declines in population, and significant urban blight. The State of Michigan appointed an Emergency Manager, Kevyn Orr, to lead the City though the restructuring process. In March, 2014 Kevin Orr and his team put forth a restructuring plan to the City's creditors that provides for needed reinvestment in City services, but low recoveries for unsecured creditors. The City's plan also proposes that the Detroit Art Collection be transferred to a trust funded by philanthropists, with the proceeds accruing solely to retirees rather than to all creditors. Kevyn Orr and his team must now find consensus on a plan that meets the needs of the City and is acceptable to its creditors.